For the 2016 model year, there are some major changes in the warranty market which will impact service contracts.
First, of course, it will increase the costs for the same service contract. Some claims that were previously covered by the manufacturer’s warranty will now be covered under the service contract. Second, the claims would be projected to occur, on average, earlier in the contract period. Therefore, the revenue should be recognized — or premium earned — more quickly than in the past.
What is the impact?
For an administrator, the reduced claims covered by the manufacturers are unwelcome news. On the positive side, the decrease in warranty terms increases the “value perception” of a service contract. Unfortunately, there are no easy answers in addressing the impact of the additional coverage without a detailed analysis of actual claims. The decrease in powertrain coverage will not increase claims equally by make, since some makes will have proportionally more claims in the powertrain portion than other makes.
The impact on service contract costs is a complicated question and there are a number of factors to consider:
- Make/model of the car: There will be variation in the powertrain claims by vehicle.
- Starting mileage: Since the time limit remains unchanged, used vehicles with remaining warranty will be impacted less. For example, a used car with 36,000 miles that is three years old will have minimal cost increase since the warranty would be active for two more years in both cases.
- Driving patterns: Notice that the time remains the same and the new term offers 12,000 miles per year while the old term averaged 20,000 miles per year
In order to calculate the impact of this change, we made assumptions which are general in nature and may not be appropriate for a specific book of business. The assumptions are that powertrain costs are 50% of total service contract costs.
In addition, we assumed claims would increase by 10% per year as the car ages. Finally, we assumed the contract holder would drive on average 15,000 miles per year, with some driving as few as 8,400 miles per year and others 21,000 miles per year at most.ESTIMATED IMPACT ON COSTS: 28%
Note that the increase in costs is only a rough estimate due to the decrease in warranty terms; it would not include any increase due to new technologies or more expensive repairs.
Why the increase in costs? Note that the previous warranty of five years/100,000 miles effectively eliminated the powertrain portion except for the last year. Relatively few drivers “miled out” of the previous warranty. Effectively, the new terms penalize the high-mileage drivers, because a normal driving pattern would not have exceeded 60,000 miles in five years by a great margin.
Earnings are also included under a “Reverse Rule of 78s” method. This method is often used for earning new car vehicles. It uses a sum-of-the-digits method in which the earnings are in proportion to the month. For example, in Month Three of a 12-month contract, the earnings would be (1+2+3)/ (1+2+3+4+5+6+7+8+9+10+11+12) or 6/73 or 8.2%. So in Month Three, a total of 8.3% would be earned.
While this method is easy to implement, it only does a fair job of approximating earnings. It tends to earn too fast early in the contract when there is very little exposure due the manufacturer’s warranty.
More interesting are the hypothetical earned experience curves. While the examples above are hypothetical, it does show that earnings will speed up to some degree under a decreasing manufacturer’s warranties.
Are you still using triangles?
Actuaries typically use triangles when analyzing service contracts. They are typically organized by purchase date, term and type of car. They are easy to produce but past trends can be problematic. In this case, the patterns in the past will show too little development at the end of the contract. If you don’t adjust for this type of exposure, you will not only be facing increased costs but may not realize for a number of years. We prefer “triangle-free” approaches using miles outside the warranty. We will discuss this more in a future article.
Of course, a detailed analysis of the specific factors in your book would be necessary to quantify the impact of a change in the manufacturer’s warranty. Extended eligibility is another concern for a couple of reasons. First, these vehicles will show significantly different earnings patterns since the expiration of the manufacturer’s warranty will occur sooner. Also, the manufacturer may extend the warranty on these vehicles.
It is important for administrators to know both the underlying cost and the correct earnings rate of their book of business. Administrators need to be prepared to understand the impact of these changes on their service contract offerings.